Incorporate Third Parties In Your Life Insurance Policy

Third-party life insurance is when the policy owner, the insured person, and the person who pays for the policy are not the same. In other words, it involves more than two people or entities sharing the four roles inherent in a policy. These roles are the insured, the owner, the payer, and the beneficiary. The insured is the person whose death triggers the death benefit, while the owner has the power to make administrative changes to the policy. The payer is the person or entity responsible for making the policy's payments, and the beneficiary is the person or entity that will receive the policy's death benefit. While life insurance policies typically involve two people or entities, there are certain situations, especially in a business context, where having distinct roles makes life insurance a useful financial tool for businesses and charities.

Understanding third-party insurance

Third-party insurance is a form of liability insurance that covers the policyholder against claims made by a third party for injuries or damages they have caused. The two main categories of third-party insurance are liability coverage and property damage coverage.

In the context of insurance, there are three parties involved: the first party is the insured, the second party is the insurer, and the third party is the person making a claim for damages or causing a loss. Third-party insurance is typically purchased by the insured from the insurance company to protect themselves against claims made by another person or entity.

A common example of third-party insurance is car insurance, which covers the policyholder in the event of an accident involving another driver. In this case, the third party is the driver who caused the damages and is not covered under the policyholder's insurance plan. Third-party car insurance typically includes bodily injury liability, which covers costs resulting from injuries to a person, and property damage liability, which covers costs for damages to or loss of property.

In some cases, third-party insurance may be required by law. For example, drivers are usually mandated to carry a minimum level of bodily injury liability and property damage liability coverage.

Third-party insurance can also be applied to life insurance policies, where the policy owner, the insured person, and the beneficiary are not the same. In this case, the insured person is considered the third party. To take out a third-party life insurance policy, the individual or entity purchasing the insurance must have an "insurable interest" in the insured, meaning they have a financial stake in the insured's continued life. For example, a business may take out a third-party life insurance policy on a key employee whose sudden death would negatively impact the company.

Proving insurable interest

To take out a third-party life insurance policy, you must have an "insurable interest" in the insured person. Insurable interest means that you would suffer financially or face some other form of hardship if the insured person died. This requirement helps to prevent insurance fraud.

In the context of life insurance, insurable interest is the emotional, legal, and financial interest that someone has in the insured person. For example, if you are the primary earner in your family, your partner or dependent children may have an insurable interest in you because they would suffer financially if you died.

• Spouse: Marriage certificate or domestic partnership registration.
• Dependent relationship: Birth certificate or documentation of legal guardianship.
• Parents: Parental consent to cover end-of-life costs such as funeral expenses.
• Business partners: Business license, partnership agreement, or shareholder agreement.
• Corporations: Employment contract, financial statements showing the employee's financial importance, meeting minutes, etc.
• Estate planning: Trust agreements and wills that name the beneficiaries.
• Legal obligations: Court orders for alimony or child support.
• Debtor-creditor relationship: Loan agreement.

It's important to note that individuals are always considered to have an insurable interest in themselves, so you can get a life insurance policy on yourself without needing to prove insurable interest. However, if someone else wants to take out a life insurance policy on you, they must prove that they have an insurable interest in you by providing legal documentation of your relationship.

Getting consent from the insured

Adding a third party to your life insurance policy can be done in several ways, depending on your situation and the type of policy you have. Here are some steps and considerations for getting consent from the insured when adding a third party to a life insurance policy:

• Understand the roles: In a life insurance policy, there are typically four distinct roles: the insured, the owner, the payer, and the beneficiary. The insured is the person whose life is covered by the policy. The owner is the person or entity that holds the policy and has the power to make administrative changes. The payer is responsible for making premium payments, and the beneficiary is the person or entity that receives the death benefit. In some cases, one person may fulfil more than one role.
• Confirm the insured's consent: Before adding a third party, ensure you have the consent of the insured, who may or may not be the same person as the owner or payer. The insured's consent is crucial, especially if they are not the owner of the policy. Respect the insured's wishes and ensure they are comfortable with the addition of a third party.
• Discuss the benefits and implications: Explain to the insured how adding a third party will impact the policy and its benefits. Discuss the financial implications, including any potential tax or estate planning considerations. Ensure the insured understands the role of the third party and how it might affect their coverage and benefits.
• Review the policy terms and conditions: Carefully review the terms and conditions of the life insurance policy. Understand the requirements and restrictions for adding a third party. Look for any specific provisions or clauses related to third-party additions. This step will help identify any potential issues or limitations beforehand.
• Obtain and document consent: Once the insured has agreed to the addition of a third party, obtain their explicit consent. This consent can be in the form of a signed consent form or another legally valid method as specified by the insurance provider. Ensure that the consent is properly documented and stored securely.
• Communicate with all parties: Keep all parties involved informed about the changes. Discuss the reasons for adding a third party and how it will benefit the insured and other beneficiaries. Transparent communication will help maintain trust and ensure that everyone understands their rights and responsibilities.

Remember that the specific process for adding a third party may vary depending on the insurance provider and the type of policy. Always refer to the policy documents, and if necessary, seek guidance from a licensed insurance agent or financial advisor.

Funding with third-party premium financing

Third-party premium financing allows policyholders to pay insurance premiums with a loan from a third-party lender. This enables individuals to secure a life insurance policy without paying large upfront premiums, allowing them to invest their funds elsewhere. The borrower is responsible for paying ongoing loan interest, with the assumption that the loan will be repaid with the policy's cash value or other means.

The policy is typically owned by an Irrevocable Life Insurance Trust (ILIT), although it may also be owned by a business or the individuals themselves. In a premium financing arrangement, the policyholder secures a loan for the value of the insurance premium from an outside lender and is responsible for servicing the loan on an annual basis. The loan interest can be paid in full each year or accrued and rolled up into the cumulative loan, which will be repaid in the future.

Third-party premium financing is commonly employed as an estate planning tool, although it may also be used to meet business needs. This financing option offers policyholders flexibility, lower upfront costs, better cash flow management, and customizable terms. It is particularly useful for clients with diminished gifting capacity or those who want to preserve their gifting for other uses.

To establish a premium financing arrangement, borrowers work with lenders, often specialised financing companies. The borrower acquires the insurance policy and assigns it to the lender as collateral, and the insurance carrier coordinates with the lender for payment. The loan amount usually corresponds to a series of annual premiums, and interest rates can be fixed or variable, depending on factors such as the loan amount, the borrower's creditworthiness, and the assets posted as collateral.

The most critical element of any premium financing arrangement is a sound exit strategy. If the policyholder passes away before the loan is repaid, the death benefit will be used to remunerate the lender before the remainder is distributed to the beneficiaries. In other cases, the cash value of the policy, a Grantor-Retained Annuity Trust (GRAT), or a liquidity event such as the sale of a business or an inheritance can be used to repay the loan.

Risks and considerations

While third-party premium financing offers benefits, there are also several potential risks and considerations to keep in mind. These include interest rate risk, refinancing risk, duration risk, adverse policy performance, and negative arbitrage. It is important to carefully review and understand these risks before entering into a premium financing arrangement.

Assigning ownership

Absolute assignment gives the new owner complete control over the policy. They can update coverage, change beneficiaries, or even cancel the policy. As the insured person, you will remain insured, but it is important to remember that the transfer of ownership is irrevocable.

Another option for assigning ownership involves using a life insurance policy as collateral for a loan. This is known as a collateral assignment and is a temporary arrangement. In this case, the policy is used as security to obtain a loan, rather than putting up property such as a home or vehicle. If the insured person dies before repaying the loan, the bank will receive the funds from the policy to cover the debt, and any remaining proceeds will go to the designated beneficiaries. Once the loan is repaid or other specific criteria are met, the original owner will regain control of the policy.

A third option for assigning ownership is to set up an irrevocable life insurance trust (ILIT), where the trust owns the policy as its primary asset. This option is often used to reduce or avoid estate taxes for beneficiaries who will be receiving a sizable taxable estate. The proceeds from the life insurance policy in the trust can then be used to purchase assets from the estate of the deceased, providing the necessary funds to pay any outstanding estate tax bills.

Frequently asked questions